How to avoid a short squeeze

As stocks rally and feds circle, short sellers face tough calls

LauraMandaro

SAN FRANCISCO (MarketWatch) -- Short sellers are being ambushed from all sides, from tighter regulations to double-digit stock gains. But there are ways to get out of the jungle alive.

Selling stocks short, which worked well as the market plunged to its bear-market lows, came back to bite practitioners as the broad market staged a swift, double-digit rally over the last month.

A watchful eye on contrarian indicators, heavily shorted stocks and safe-haven investment flows -- plus an ear for market sentiment -- can help investors determine when it's time to get out of, or back into, a short-selling strategy.

"You want to look for extremes," said Paul Brigandi, vice president of trading at Direxion Funds, which runs $5 billion in exchange-traded and mutual funds, including leveraged short funds such as Direxion Financial Bear 3X Shares
FAZ, +0.61%

That largely means watching the metrics that signal investor fears have gone too far, such as highs in the CBOE Volatility Index, called the Vix
VIX, -3.32%
and gold prices, as well as lows in Treasury-bond yields and investor-sentiment surveys. When investors are hunkering down in cash, Treasurys and gold, the thinking goes, stocks may have sold off too much and are ready to rally.

"A huge amount of money sitting on the sidelines and in safe havens creates a recipe for a snapback," Brigandi said.

Retail investors can engage in short sales -- placing bets that an individual stock or a broader sector will fall -- by borrowing stock through a margin account or purchasing exchange-traded funds or mutual funds that engage in short trades. E-Trade Financial Corp.
ETFC, +0.45%
and Scottrade, for instance, allow investors to sell stock short with as little as $2,000 in a margin account.

Prescription for heartburn

To execute a short sale, investors borrow stock, then sell it. If the shares fall, they can buy them back at a lower price, return the securities to the lender and pocket the difference as profit.

It was an attractive strategy as U.S. stocks were moving toward 12-year lows earlier this year. But in the past month, they rebounded quickly and dramatically, with the S&P 500 jumping about 27%. Some beaten-down stocks, such as Wells Fargo & Co.
WFC, -0.69%
and Bank of America Corp.
BAC, +0.39%
made gains of that magnitude in a single day's trading. See Financial Stocks.

This climate spells heartburn for short sellers. When a lot of investors suddenly want to buy a stock, brokers can require short sellers to return those borrowed shares. To "cover" their positions, short sellers need to buy shares in the market -- perhaps at higher prices than those at which they originally sold them, triggering a loss.

What's worse, demand from a multitude of short sellers trying to cover their positions at the same time can send prices even higher -- that's known as a short squeeze.

"This is a very high-risk environment to be short," said Doug Noland, a senior portfolio manager on Federated Investors' $1.3 billion Federated Prudent Bear Fund
BEARX, -0.16%
"Short squeezes can be dramatic, and a lot of money can be lost."

The dramatic recent rallies in the broader market and in some specific sectors have battered short sellers who bet against company stocks and index-based ETFs.

Take recent action in SPDR Financial Select
XLF, -0.23%
an ETF that tracks financial companies -- and was the fourth-most-shorted stock on the New York Stock Exchange at the end of March. Bad news for these shorts: The ETF has rallied 72% since the S&P 500 hit its bear-market intraday low March 6.

SPDR S&P 500
SPY, +0.35%
an ETF that tracks the S&P 500
SPX, +0.36%
was the second-most-shorted stock on the NYSE. It's vaulted 25% since March 6.

Under pressure from lawmakers and from banks, the Securities and Exchange Commission is considering five approaches to reinstating the uptick rule, which restricts the short selling of stocks that are in decline. Read more on the uptick rule.

Regulators can crack down even more heavily on short selling when certain sectors are getting pummeled. Last year the SEC placed a temporary restriction on short selling in nearly 800 financial institutions' shares. Read about that ban.

Bear tracks

In this dicey environment, retail investors have to keep a close eye on signs that a bear market is about to turn bullish.

One signpost is a jump in the Vix to levels exceeding 80%.

The index, which reflects expectations for future volatility in S&P 500 stocks, rose to about 81% on Nov. 20. Over roughly the next seven weeks, the S&P 500
SPX, +0.36%
gained 24%. Read more about the Vix.

A steep jump in gold prices and Treasury bonds, two asset classes that are traditionally bid up when investors are feeling particularly pessimistic about stocks, can also flag a coming rebound in stocks.

Two weeks after gold prices shot past $1,000 an ounce on Feb. 20, the S&P 500 hit its bear-market intraday low of 666.

Low Treasury yields, which fall as bond prices climb, can also signal stocks are readying for a rebound -- though the reversal can take time.

Starting in mid-September, in the wake of the Lehman Bros.
LEHMQ
collapse and the bailouts of American International Group
AIG, +0.02%
Fannie Mae
FNM, +7.06%
and Freddie Mac
FRE, +3.59%
investors were so hungry for safe, liquid government debt that they were willing to do without any interest payments at all on the shortest-term Treasurys.

"That's not a normal market when that starts to happen; that's extreme fear," said Direxion's Brigandi.

The S&P 500 hit new lows after 1-month T-bill yields skirted 0% in September. But by December it was rallying, a bad turn for shorts.

Sharp gains in heavily shorted stocks or sectors can spell trouble for short sellers everywhere, Prudent Bear's Noland said. "We don't like to see stocks with big short positions outperforming the market," Noland said.

Citigroup
C, -0.29%
the most shorted stock on the NYSE, has tripled to just over $3 a share since March 6.

On Wednesday, Bed Bath & Beyond Inc. shares
BBBY, -0.42%
jumped 23% after the retailer posted a smaller-than-expected profit decline. Investors had sold about 12% of its shares short, a relatively high proportion. Read more on Bed Bath & Beyond.

And in October, the German automobile manufacturer Volkswagen AG (766400) briefly became the world's largest company by market capitalization after hedge funds shorting the stock -- caught by surprise when Porsche Automobil Holding (PAH003) revealed a larger stake in the company -- made a forced grab for shares to cover their short positions.

Intense bidding for the few shares owned by the public quadrupled the value of VW shares in just two days.

The New York Stocks Exchange maintains a list of the most shorted stocks on its Web site. See the NYSE list.

In any market, professional short sellers say it's easy to get burned by focusing on a company's fundamentals and ignoring sentiment among investors.

That was a lesson many short sellers learned the hard way in the late 1990s, as stocks in start-up technology companies skyrocketed along with a general equity-market euphoria, even if the companies had booked no profits and faced questionable prospects. Many later went bust, but only after handing heavy losses to short sellers along the way.

"All companies, even companies that are total frauds, are susceptible to emotional responses to overall market action," said Manuel Asensio, managing member of Mill Rock Investment Advisors, a hedge-fund manager that engages in short selling and other strategies.

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